CFA Level II ExamEquity InvestmentsEasy
A real estate investment trust (REIT) analyst is using the dividend discount model (DDM) to value a publicly traded REIT. The REIT is expected to pay a dividend of $2.00 next year, and these dividends are expected to grow at a constant rate of 4% indefinitely. The required rate of return for the REIT's equity is 10%. What is the intrinsic value per share of the REIT?
- A$50.00
- B$52.00
- C$33.33
- D$20.00
Show answer & explanationAnswer & explanation
Correct answer: C. $33.33
The intrinsic value per share using the Gordon Growth Model (a one-stage DDM) is calculated as D1 / (r - g), where D1 is the next year's dividend, r is the required rate of return, and g is the constant growth rate. Value = $2.00 / (0.10 - 0.04) = $2.00 / 0.06 = $33.33.
Why the other options are wrong
- A. Incorrect calculation. This would be $2.00 / 0.04, using growth rate as the discount rate.
- B. Incorrect calculation.
- D. Incorrect calculation. This would be $2.00 / 0.10, ignoring the growth rate.
Gordon Growth Model (GGM)
A single-stage dividend discount model that assumes dividends grow at a constant rate indefinitely and discounts these future dividends back to the present to determine the intrinsic value of a stock.
- Formula: V0 = D1 / (r - g), where D1 is next year's dividend, r is the required return, and g is the constant growth rate.
- Assumes g < r for a finite value.
- Most suitable for mature, stable companies with predictable dividend growth.
Memory trick: Dividend next, over rate minus growth, for value best.